One of the most important things my father taught me about money matters is investing for retirement. Based on his advice, I opened an IRA at age 19 and have been investing ever since. When I first started investing, I was eligible for an IRA, but I was in the USAF and we did not have a 401(k) plan. It wasn’t until I was in for about two years that the military had an equivalent plan, the Thrift Savings Plan (TSP).
At that point, I wasn’t earning enough money to fully max out my IRA and contribute to the TSP. I had to decide which investment plan was the best for me. Since I didn’t receive a “company” match to my TSP, I chose to invest in a Roth IRA. (Why choose Roth over Traditional?)
In my current situation, I have a 401(k) plan with my employer, and I have the option of investing in an IRA plan as well. I face the same question a lot of people face: where should I invest my retirement funds – in a company 401(k) plan, or in an IRA?
Company 401(k) Plan: Company 401k plans are similar to Traditional IRAs as far as taxes go – contributions are invested before taxes are withdrawn, which can lower your adjusted gross income (AGI), giving you a tax break now. The invested money will be taxed when withdrawn at retirement age, and there are stiff penalties for early withdrawal. There is also the possibility of investing in a Roth 401(k), although not all employers offer this option. The maximum annual contribution amount is the same as a 401k and is set at $15,500 for 2008.
A distinct benefit in favor of 401(k) plans is a possible company match, which is essentially free money for employees. My current company offers a 401(k) match of up to 1.5% of my pay. It isn’t very much, but it is free money and I take advantage of every penny of it!
IRA: There are two main types of Individual Retirement Accounts: Traditional and Roth. (I have chosen not to focus on SEP IRAs, SIMPLE IRAs, or other forms of IRAs as they are not applicable to everyone).
- Traditional IRA: The main benefit of a Traditional IRA is that the money can be fully or partially deductible, depending on your situation. The money is invested before taxes are withdrawn, which can lower your AGI, resulting in an immediate tax break. The invested money will be taxed when withdrawn at retirement age, and there are stiff penalties for early withdrawal (barring certain exceptions).
- Roth IRA: Roth IRAs are non-deductible, which means you use post-tax money to fund your account. However, the distributions made during retirement age are tax exempt, which is the main reason people invest in a Roth IRA. As with the Traditional IRA, early withdrawals may incur stiff penalties.
- For both IRAs: These are individual investments, meaning there are no company matches. There may be certain tax or eligibilty restrictions for Traditional or Roth IRAs based on your income, filing, and marital status. The investment limit for 2008 is $5000.
Pros and Cons of 401(k) Plans and IRAs
401(k): The biggest benefit of a company 401(k) plan is the possibility of having a company match. Free money is something you shouldn’t pass up, especially when it will compound over time. On the downside, some company 401(k) plans may have a limited selection of funds to choose from. Your investment options will be limited to whichever funds are in the company plan, which can be detrimental if your plan consists primarily of funds with high expenses.
IRA: With IRAs, all investment responsibility lies with the individual. He or she must decide where to invest, how much to invest, etc. This can be overwhelming for some people, but there is always the option of paying someone to manage your funds. The benefit of controlling your investment is the flexibility of deciding where to invest: funds, stocks, bonds, ETFs, etc. the possibilities are limitless. The other benefits of IRAs include controlling your tax diversification options by investing in a Roth IRA for tax free withdrawals, or investing in a Traditional IRA to lower your AGI and current tax obligations.
Where Should You Invest?
Only one of these types of retirement plans involves the possibility of free money – the company 401(k) plan. If your company offers a match, it is probably in your best interest to invest in a 401(k) plan at least to the point of receiving the maximum company match. It is hard to pass up free money!
After you have put in enough money to get the match, I would consider investing in a Roth IRA because you will be able to withdraw this money tax free in retirement. Doing this diversifies your future tax liabilities by having a taxable and non-taxable retirement funds.
If you have enough money to invest for the full company match, and max your Roth IRA, then you should consider investing more money in your 401(k) plan. This will ensure you maximize your retirement contributions, and diversify your tax obligations both now and in retirement.
Always Research Your Investment Options Before Investing!
These are only my recommendations based on common situations. You should always ensure your investment decisions are based on your needs and the amount of risk you are willing to take. The most important thing is to get started and keep investing. Your future is worth it! 
By, the way… for those who are curious, I max out my Roth IRA, and invest in my 401(k) plan above the amount of my company match. My goal is to funnel as much money as possible into my retirement accounts while I am young and able to do so!
{ 18 comments… read them below or add one }
Your comments are spot on for the vast majority of people. My only addition would be to address the income caps that come with the Roth IRA (make too much money and won’t qualify). The alternative is a non-deductible IRA which is a third type of IRA that is outside the scope of your post. Oh, I would also add that ideal situation for a Roth IRA is if your income is current taxed at a lower rate than your likely tax rate in retirement (pay tax now at a low rate rather than later at a higher rate). Great post.
Bingo man, I couldnt agree more. 99.99% of the time you will be in a higher tax bracket when you want to retire (and also want to KEEP withdrawing a higher amount) so max company match on 401k then roth is def the way to go.
Jesse, thanks for the reply. My company just announced they will offer the Roth 401(k) starting in a few months, so I think I may look into investing in that. I think it is a great opportunity.
Adfecto, Thanks. It is tough to cover each rule the IRS imposes for IRAs, 401(k) plans, and other tax rules. There are always a lot of exemptions and exclusions. I appreciate the info and comments.
The match is key since most 401(k) plans have sky high expense ratios and limited choices. So never underestimate the importance of it.
And please max out your Roths people!
You are doing it the right way. Don’t leave any match dollars on the table, then fund your Roth, then work toward maxing out your 401(k).
Best Wishes,
D4L
Thanks for the nice article. I myself like cutting my taxable income by putting as much as possible into a 401k. I think that over time whether you invest into 401k or a ROTH ira doesn’t matter, as long as you contribute for retirement.
The tax free benefit of the Roth is based in part on faith the government will ‘play fair’ decades from now. I think they will be eye Roths as a hungry wolf eyes a lamb.
I max out my 401K limit to the current 15500, and if I have any left it goes in a Roth. We also are working on being debt free. Hopefully in my mid 50’s (ten years from now) we will be debt free and can both max our 401K’s and Roths to the limit, including the catch-up limits.
One thing to check on is whether either spouse can take part in either a Health Savings Account, or some other form of yearly medical savings plan. The ones you have to ‘estimate’ the next years med expenses (you lose any excess) are a pain, but if you have big “Known” medical costs looming (eyeglasses, braces, operation, Lasik, etc.) you can basically get 30-40% of these costs back in the form of a tax break.
Another VERY important thing to take into account is the state you live in now and the one you will retire to:
I pay in to my 401K now in the highest tax state in the union, New York. So my tax break realized right now is 40% or more. If I pick a low state tax state to retire to, say the total Fed & State damage is 25%, It will make the 401K a 15% better deduction than the Roth.
If you are from high tax states NY, CT, MA, PA, OH, IL, MD, etc you should take this into account.
Is it possible to have a 401(k) AND an IRA at the same time? Just wondering…
Hello Richard, Yes, you can have both a 401(k) plan, which is sponsored through an employer, and an IRA, which is directed by the individual.
You can invest in both at the same time, only in one or the other, or in neither. They are subject to contribution limits and some other rules.
Generally it is best to contribute to a 401(k) plan up to the company match before contributing elsewhere because that is free money. Then decide where it is best to contribute any additional funds.
My husband is putting in the max matched at his company 401k. Last year he pulled most of that ($34,000) and put it into a traditional ira. he put the ira in a 7 month cd because he’s thinking about pulling $20,000 from it in July to pay off his truck and rolling the balance into a roth. He will continue to put into his 401k until he retires in another year. This is our plan at this point — what would you advise?
Thanks.
Infor on 401K. I put in 15%. I think they only match up to 5%.
Hello,
I’m in shock! I just got a letter from the IRS asking for 1300. plus penalties for my 2007 return. I contributed the max to my company 401K and opened an IRA for 5000 that year. My bank and employer advised adding the 5k as I was over 591/2 and eligible.
Now the IRA is disallowing it and I’ll be hit for the 2008 return also. Did I make a mistake? Will I be able to ‘remove’ that 5k from my IRA – I don’t want to be hit with taxes when I withdraw.
Thank you!
Robson, It’s possible there was an error in either the information you were given or an error on the part of the IRS. Another possibility is contributing to an IRA when you were above the contribution limit. For example, if you contributed to a Traditional IRA and claimed a tax deduction, but earned too much to qualify.
My recommendation is consulting with a CPA for more information specific to your situation.
“Only one of these types of retirement plans involves the possibility of free money – the company 401(k) plan. If your company offers a match, it is probably in your best interest to invest in a 401(k) plan at least to the point of receiving the maximum company match. It is hard to pass up free money!”
I think every one need to read this one. ran into a friend of my daughters who was telling me 401K was a waste of time. I showed her using the savers tax credit she could invest 350 bucks and get a 2000 investment in her 401K.
One thing worth considering: the way the company MATCHES the employee contribution! For example, I worked for a company that matched at the 6% (3%) level – but only with its own stock. When their share price went from the $20’s to the $6’s, you can imagine the results. Second consideration: compare the expense ratios on the 401K’s mutual fund offerings with the closest equivalent fund, or that same fund, available on the open market. Often a company 401K plan expense ratios are outrageous!
Great points, Mitch. Another consideration is vesting period. Most companies make employees wait a couple years before they can take matching contributions with them when they leave. The last two companies I worked for had a year vesting period, though you could be partially vested after 3 years.